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OSI Systems, Inc. (NASDAQ:OSIS)

Q3 2006 Earnings Conference Call

May 15, 2006, 5:30 p.m. EST

Executives

Deepak Chopra – Chairman and Chief Executive Officer

Ajay Mehra – President, OSI Security Group

Victor Sze – General Counsel

Anuj Wadhawan – Chief Financial Officer

Analysts

Brian Ruttenbur – Morgan Keegan & Co., Inc.

Navid Malik – Collins Stewart

Jeff Rosenberg – William Blair & Company

Josh Jabs – Roth Capital

Tim Quillan – Stephens, Inc.

Presentation

Operator

Good day ladies and gentlemen, and welcome to the Q3 2006 OSI Systems Earnings Conference Call. My name is Tony and I’ll be your coordinator for today. At this time all participants are in listen-only mode and we will conduct a question and answer session towards the end of this conference. (Operator Instructions)

I now turn the call over to Mr. Victor Sze, General Counsel. Please proceed, sir.

Victor Sze

Thank you very much and good afternoon. With me on the call today are OSI Systems Chairman and CEO Deepak Chopra, the president of the OSI Security Group, Ajay Mehra, and OSI’s Chief Financial Officer, Anuj Wadhawan.

During our presentation this afternoon, we will make forward-looking statements concerning upcoming events and our expectations regarding the Company’s financial performance. Each time we do, we will try to identify these statements with words such as expect, believe, anticipate, or other words that indicate potential events. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those in the forward-looking statements.

Please consider the risk factors contained in today’s press release and stated during this conference call, as well as the risk factors described in our latest Form 10K filed with the SEC.

For a limited time we will make the webcast replay of this presentation available on the investor relations section of our website. Our website address is www.osi-systems.com.

Please note that the date of this conference call is May 15, 2006. Any forward-looking statements we make today are based on assumptions that we believe to be reasonable as of today. We undertake no obligations to update these statements as a result of future events.

Finally, this conference call is a property of OSI Systems and any recording, reproduction or rebroadcast of this conference call without the express written consent of OSI Systems is prohibited. I’ll turn the call over now to our CEO, Deepak Chopra.

Deepak Chopra

Thank you very much Victor. Before I go into the quarter, I want to mention that I am speaking from New York City where I’m currently participating in our trial with L-3 Communications.

The trial has just entered the third week and is expected to last for approximately four weeks. As you can expect, I am unable to comment or answer any questions regarding the progress or potential possible outcome of the trial until its conclusion.

I thank you very much for your understanding and patience regarding this matter.

For the third quarter of fiscal 2006, the company recorded revenues of $108.1 million with diluted earnings per share of $0.06, after stock-based compensation expense of $1.5 million or $0.09 per diluted share.

Anuj Wadhawan, who is currently in Los Angeles, will discuss the financial highlights in further detail at the conclusion of my operational review and then we will open it up to questions.

Overall, we are pleased with the operating performance for the company as a whole in all of its three operating segments. We are particularly pleased with the Security segment recording record revenues of $36.7 million and returning to profitability, which we said in our last conference call. We expect this performance to continue into the fourth quarter of this fiscal year.

The revenue growth and operating income performance for the Security business was primarily led by the strong performance of our Cargo and Vehicle product line and continued robust revenue stream from our people and parcel scanning conventional business.

Year to date, we have announced an excess of $28 million in new Cargo orders from both international and domestic customers. The backlog for the Cargo product stands at approximately $44 million to $43 million at the end of the quarter with the total Security business’s backlog to be at a very healthy level. We continue to see increased traction for the product line globally, especially Cargo, led by the U.S. Government and strong performance should continue into the fiscal 2007.

The Security business will continue to be committed to R&D both for its Cargo product line and the Automated Hold Baggage Screening market, although we did say in the last conference call that the R&D going forward for the Cargo line, is relatively lower and reducing, and the R&D for the Hold Baggage Screening line is increasing.

We also introduced our first product offering in the hold baggage market in this quarter.

A major focus of our R&D spending will be on the commercialization of the Rapiscan RTT1000 CT system for Automated Hold Baggage inspection. As for before, the system utilizes our proprietary Real Time Tomography technology for the automated inspection of hold baggage. The system is electronics-based without any moving parts that by design will increase baggage throughput from the present machines doing approximately 500 to 600 bags per hour, to increase the throughput to approximately 1500 bags per hour. We believe the system will radically reduce installation and ongoing maintenance cost, which associated with the current systems is the big problem in the market.

This quarter we announced a $7 million order with the Manchester Airport Group, which was one of the original groups to go towards CT scanner technology for automatic hold baggage. If all the customer options are exercised, the order could be worth approximately $40 million. We are expecting to deliver the product in fiscal 2008 and we are at present, wrapping up R&D towards what we call scaling it in size and to continue to work out the various sub-systems of the system.

Healthcare business. The third quarter of our healthcare business, as we have mentioned, is seasonably weaker when compared to the businesses in the—especially in the second quarter ending December and the fourth quarter ending June. Despite the seasonal factors, our monitoring and anesthesia business continues to show year-on-year order book growth.

For the first nine months of the fiscal year, monitoring order book growth globally has increased by 18%. The growth has been led by the continued strength and strong performance in the U.S. market, which is the biggest market for the monitoring products. The business has and remains focused on recapturing our replacement cycle business. Published industry growth rates show the market growing at approximately 3-5% in the U.S., similar number in Europe and about 10% in Asia-Pacific. Our order book growth clearly indicates that we are achieving our internal goal of recapturing our installed base while also capturing market share from our competitors.

Gross margins for the Healthcare business continued to improve and approached 48% versus 46% over the first three quarters as a whole over the fiscal year. The improvement is attributable to the introduction of new products in the patient monitoring line, and the achievement of efficiencies in the manufacturing process in our monitoring and anesthesia product lines, and the growth in our revenue.

The business although, is facing a challenge in the U.K. and German markets primarily due to the government spending cycles, a challenge that we are not alone but us and all our competitors are also facing.

This quarter, the company also reached a settlement with Masimo regarding our Dolphin ONE digital pulse oximetry products. Under the terms of the settlement, we agreed to discontinue the product line of Dolphin ONE digital pulse oximetry. The financial impact of this is expected to be minimal and immaterial.

Take focus of that product line is in our original equipment manufacturing relationships for continuing to make oximetry products for other patient monitoring companies and supplying products under the name Tru-Link or Spacelabs.

The Healthcare business is focused on organic growth in all the product lines and we are looking to introduce new technologies and products while also focusing on the introduction of the anesthesia product line into the U.S. market sometime in fiscal 2007. We continue to look at acquisitions; globally it is part of our strategy. We internally have said that we would target the Healthcare business to approach approximately half a billion dollars in revenue over the next two to three fiscal years, combination from acquisitions and from internal organic growth.

Any acquisition we look in that product line, we target towards making it accretive to both Spacelabs and OSI in a very short period. The Optoelectronics business continued its great performance in fiscal 2006. The business has benefited not only from the general pick up in the economy but also the improved performance in our Security and Healthcare businesses.

This quarter we achieved record inter-company sales of $7.6 million. This has helped in pushing the operating income for the business for the quarter. This quarter we also announced the resignation of Deloitte & Touche as our independent accountants. We had been with Deloitte & Touche for the past 15 years and thank them for their service. We welcome our new auditors, Moss Adams, and looking forward to a long-solid relationship with respect from both sides. The resignation, as we have discussed, of Deloitte & Touche was primarily due to relationship issues and not in any way associated with financial reporting procedures of the company.

For the six months ending June 30, 2006, we expect revenues to be between $231 and $236 million, an increase of approximately 18% when compared to $196 million achieved in the second half of fiscal 2005. We will be profitable and expect that operating income will be significantly higher in Q4 when compared to Q3. Overall, we are well-positioned to finish the year on a strong note setting us for a successful growth-oriented 2007.

With that, I will hand it over to Mr. Anuj Wadhawan to give the detailed financial information.

Anuj Wadhawan

Thanks Deepak and good afternoon everyone.

Financial highlights for the (three) and nine months of fiscal 2006.

Our revenues for the third quarter of fiscal 2006 increased by $13.9 million or 15% to $108.1 million compared to $94.2 million for the third quarter of last year. Revenues for the first nine months of fiscal 2006 increased by $42.8 million or 15% to $327.1 million from $284.3 million for the first nine months of fiscal 2005.

Net income for the third quarter of fiscal 2006 was $1 million compared to a net loss of $2.9 million for the third quarter of last year. Net loss for the nine months of fiscal 2006 was $3.1 million compared to net income of $840,000 for the first nine months of last year.

Diluted income per share for the quarter was $0.06 compared to diluted loss per share of $0.18 for the third quarter of last year. Diluted share for the first nine months was $0.20 compared to diluted income per share of $0.05 for the first nine months of last year.

Due to the adoption of FASB 123r in the first quarter of fiscal 2006, we recorded stock-based compensation expense of $1.5 million in the third quarter and $4.1 million in the first nine months of fiscal 2006.

To give you the breakdown of revenues, on the Security side of our business, revenues increased by $7.4 million or 26% to $36.4 million this quarter compared to $29 million for the last year’s third quarter. The increase was primarily due to an increase in revenues of $4.8 million or 101% in our Cargo and Vehicle Inspection products and $2.6 million or 11% in our conventional (base) business which comprises of baggage, parcel and people screening products.

For the first nine months of fiscal 2006, the Security group revenue increased by $2.8 million or 3% to $93.8 million from $91 million. The increase was primarily due to increase in revenue in our conventional (base) business of $7.2 million or 10% and was partially offset by decrease in revenues of our Cargo and vehicle inspection products.

On the Healthcare side of our business, the revenue increased by $1.6 million or 3% to $49.4 million in the quarter compared to $47.8 million in the last year’s third quarter. For the first nine months of fiscal 2006, revenue increased by $17.2 million or 12% to $161.8 million compared to $144.6 million in the first nine months of fiscal 2005. The increase in revenues in the quarter and nine months was primarily due to increased revenues from our monitoring and anesthesia systems.

On the Optoelectronic side of our business, external revenue increased by 28% to $22.2 million in the third quarter compared to $17.3 million in the last year’s third quarter. External revenues for nine months increased by $22.8 million or 47% to $71.5 million from $48.7 million in the last year’s nine months. The increase in revenues in the quarter and nine months was primarily due to an increase in revenues of both Commercial Optoelectronics and higher contract manufacturing levels. In addition, during the quarter we recorded an inter-company revenues of $7.5 million compared to $5 million in the third quarter of fiscal 2005 and $5.4 million in the second quarter of fiscal 2006, which got eliminated in the consolidation.

Our gross margin for the quarter increased to 39.8% compared to 35.2% in the last year’s third quarter and 38.5% in the second quarter of fiscal 2006. Our gross margin for the nine months increased to 38.3% compared to 36.4% for the last year’s nine months. The increase in gross margin was primarily due to favorable change in product mix in all of our three businesses.

SG&A for the third quarter was $33.8 million compared to $30.2 million for the last year’s third quarter and $33.5 million for the second quarter of fiscal 2006. The increase in SG&A in the third quarter, compared to last year’s third quarter, was primarily due to increased legal fee of approximately $1.9 million associated with the ongoing litigation of L-3 and SAIC, and the inclusion of approximately $1.2 million in stock compensation expense and higher administrative costs to support the growth of our businesses. The increase was partially offset by the impact of an increase in bad debt reserve of $2.5 million in the three months ended March 31, 2005.

SG&A for the first nine months of fiscal 2006 was $100.7 million compared to $80.6 million for the last year’s nine months. The increase in SG&A was primarily due to increased legal and professional fees of $5.2 million, higher administrative cost of $2.2 million, inclusion of stock-based compensation expense of $3.4 million, $2.7 million due to inclusion of full nine months of Blease SG&A, higher sales export cost of $7.2 million to support the growth of our three businesses and foreign currency translation losses. The increase was partially offset by the impact of an increase in bad debt reserve of $2.5 million in the three months ended March 31, 2005.

R&D for the third quarter of fiscal 2006 was $8.9 million compared to $7.3 million in the third quarter of last year and $8.7 million for the second quarter of fiscal 2006. R&D for the first nine months of fiscal 2006 was $26.3 million compared to $21 million in the first nine months of fiscal 2005. The increase in R&D spending was due to increased R&D spending by our Healthcare group for the development of next generation products and increased R&D spending for the development of our Automated Hold Baggage Screening and Cargo and Vehicle Inspection Systems by our Security group.

We had an income tax benefit of $820,000 for the third quarter of fiscal 2006 compared to a tax benefit of $2 million in the third quarter of fiscal 2005.

For the nine months of fiscal 2006, we recorded a tax benefit of $1.8 million compared to a tax benefit of $602,000 for the last year’s nine months. Our tax rate is dependent on the mix of income from U.S. and foreign location due to tax rate differences.

Our effective tax rate has increased due to inclusion of incentive stock option expense in the total stock compensation expense which does not qualify for tax deduction. We expect our tax rate in the fourth quarter will be impacted as we adopt (NYSEARCA:FAS) 109-2 to repatriate our foreign earnings. We are currently evaluating the impact of this.

In the first nine months of fiscal 2006, we used approximately $10 million of cash in operating activities, primarily for working capital to support the growth of our businesses. Our total backlog remains strong at the end of March of approximately $131 million, our Cargo backlog at the end of March was approximately $43 million. We reiterate our revenue guidance for the second half of fiscal 2006 to be in the range of $231 million to $236 million and expect revenues and operating income be higher in the fourth quarter when compared to the third quarter of fiscal 2006.

With that, I will open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from Brian Ruttenbur with Morgan Stanley. Please proceed.

Brian Ruttenbur

Hi, this is Brian Ruttenbur of Morgan Keegan, I don’t get paid like the guys at Morgan Stanley. A couple quick questions for you on the tax rate, you expect it to be up significantly from third quarter levels, or we talking 45-50%, we talking 35%, what range are we talking?

Anuj Wadhawan

If we look at the third quarter we had a benefit, income tax benefit and in the fourth quarter, we (inaudible) but there are various different variables out there and one is the stock compensation expense and repatriation. Tax rate is going to be higher, it’s going to be over 50-70% range.

Brian Ruttenbur

Okay, so on a GAAP basis it would be over 50%?

Anuj Wadhawan

Yes, it will be between 50-70%.

Brian Ruttenbur

Okay. And then legal fees, you mentioned in the quarter was $1.9 million I believe, it’s what I caught. What kind of legal fees do you anticipate in the quarter we’re currently in, given the trial and everything?

Anuj Wadhawan

Just to clarify, $1.9 million is the incremental over the prior year, third quarter.

Brian Ruttenbur

Okay, how much legal fees did you actually have in the third quarter?

Anuj Wadhawan

Approximately $2.7 million.

Brian Ruttenbur

Okay. So you have 2.7, what do you anticipate in this current period?

Deepak Chopra

Well, let me try to answer that question, cause I’m in New York. Brian, very difficult for us to come up with a number. We definitely think that the best estimate we can give you, it would be higher than Q3. But at the same time, it will drastically go down by the end of this quarter. By the end of this month.

Brian Ruttenbur

Okay. That’s fair. The other outstanding large, I guess, litigation is the only one that I am aware of is SAIC, is that the big one out there? Is there anything else major besides that?

Victor Sze

No, Brian. It’s Victor Sze, those really are the two that are sort of the larger part of our legal fees. The others are more minor.

Brian Ruttenbur

Okay. And then, let me just talk about gross margins. You had good gross margins in the period, in the third quarter and that’s over the last, I guess, six or seven quarters, that’s your highest gross margin overall. Can you maintain that 40%? Is that the goal?

Deepak Chopra

I think that a lot depends on the Security shipments and as we have said that fourth quarter would continue to show growth if compared to Q3. So, there is no reason why the gross margin should not continue to tick upwards approaching the 40% plus number.

Brian Ruttenbur

Okay. On SG&A, just going down through the income statement for the next period. It’s seasonally very heavily-weighted Q4, I think that because of bonuses and salary increases and everything that takes place in the fourth quarter. Is that the case?

Deepak Chopra

I don’t know. Maybe, Anuj, you want to take it. I think that the bonus accrual goes all through the whole year and there are no raises or something that come in to fourth quarter. I think it’s more like the hourly people gets reviewed in August and (the rest) gets reviewed in September. So, I don’t think so that’s true. Anuj, you want to add on to it?

Anuj Wadhawan

Yeah. The fourth quarter, another factor kicks in is the professional fee associated with the auxiliary testing on Sarbanes and coming from the auditors. That’s another variable coming in to it. And another variable comes with the commission of our internal sales force. As in the Healthcare business, their compensation is based on the revenues. They have their sales targets. As we come to our fiscal year end, and they approach their sales targets, they have commissions on that.

Brian Ruttenbur

Okay. So, seasonally the fourth quarter is much heavier even as a percentage of revenue, that’s what it has been at least. Is that fair to say this year?

Anuj Wadhawan

If you take it as a percentage of revenue, I don’t think it’s going to increase significantly. They all depend on the variable, as legal, as Deepak mentioned, is going to be higher. But if you exclude that, if not, our SG&A is pretty much in the lower (inaudible).

Brian Ruttenbur

Okay. And then, finally, on R&D, it sounds like it’s going to be up in the fourth quarter versus the third quarter, did I hear that right?

Deepak Chopra

That’s true.

Brian Ruttenbur

Okay. Can you give us a range? Is it going to be up by 1 or 2 million or what?

Deepak Chopra

Ajay, you want to comment on it, because the only area that is up, going to be up, is not Medical but your RTT Automated Baggage Scan.

Ajay Mehra

Yeah. I mean, obviously, we are ramping up on the R&D there, Brian. It’s going to be up, but I would say it’ll be up by less than a million dollar quarter to quarter.

Brian Ruttenbur

Okay. And everything else should be down or flat, beyond that, for the rest of the Company. Is that right, Deepak?

Deepak Chopra

I think the answer is flat is a better answer than down.

Brian Ruttenbur

Okay. Great. So…

Deepak Chopra

But just to complete your first sentence on the SG&A, just thinking about it, what Anuj was saying. As a percentage of revenue, I don’t think so that your SG&A is going to be higher in Q4 compared to Q3, because if you look at our guidance, Q4 revenue is going to be significantly higher than Q3.

Brian Ruttenbur

Yes. Okay. That makes sense. And then, I guess, last question, I’ve asked way too many, but I just want to understand a little bit more on the Security side. What all is going out there from a macro environment? What is up for bid right now? Where is the big action? Is it in the US, is it Europe, is it Asia? Where are the big, large Cargo and other contract award expected?

Deepak Chopra

Ajay, you want to take that?

Ajay Mehra

Yeah. I think on the large Cargo side of things, we’re seeing activity both internationally and domestically. We’re actively talking to, participating in various government agencies over here. Internationally, again it is very strong, activity is very strong, stronger than what we’ve seen it, in fact, ever before. On the financial side, our people and parcel scanning business, we continue to see growth. Anuj mentioned that we were at 10%, 11% higher than previous quarters. We are seeing growth there, we are looking at newer markets that we’re entering overseas. And the Automated Hold Baggage Screening, that’s just a market that we started. We are obviously looking at customers that have been with us in different airports, and they are the same customers. So we think that we’re going to get some good traction there as we’re going forward. So really, all three areas of our business are looking very strong.

Brian Ruttenbur

Okay. Thank you very much.

Operator

Your next question comes from the line of Navid Malik with Collins Stewart, please proceed.

Navid Malik

Thanks for taking questions. Three questions. In terms of your revenue growth from patient monitors, you’re signaling that growth in the global market or the order intake was at 18%. How long do you think this growth will continue for, given the market’s growing low single to mid-single digits? And where do you see particular inflection point in terms of new products coming through. I’ll ask the next two questions after you answer this one.

Deepak Chopra

Number one, that’s very true. Our growth, what we have said to you for the last 4, 5, 6 quarters that we’ve been talking about, we continue to see double digit growth. Our U.S. business, surprises me, had been very strong in monitoring, order intake, which basically says that not only are we capturing our lost market share, but we’re also taking business away from our competitors. Definitely non-U.S., we have some challenges still as you know that that area was started when the company separated from GE from scratch and we are still building our sales force, we are still building our relationships. In the Asia Pacific, we continue to make progress. We have new products in line, the closest one is the low acuity monitor especially geared up for the low cost fair market to go after the outer clinics and the Asia Pacific area. Our major launch for a whole new platform is not scheduled ‘til late 2007, 2008. But the other initiative is, as you know, that we have 510(k) approval for anesthesia machines in U.S., and we are in right now in our final strategic plans of launching the anesthesia product line into U.S.

So there is a lot of activity happening in that area. Answer to your question how long can we continue this double digit growth? We’ve said it that for the next foreseeable future, we will continue to see this double digit growth and we don’t see any slowdown in the short period. Where it will end up in the inflection point, I think it’s still 4, 6, 8 quarters out.

Navid Malik

And just on the anesthesia business, do you think that given the strength of that business in the rest of the world, that you could see a pretty confident launch in the U.S.? What are your expectations or preparations for launch of anesthesia products in the U.S.?

Deepak Chopra

Well keep in mind that U.S. is the biggest market for the anesthesia products. So, even if it’s huge market, but we’re also coming in. You can appreciate it that Drager Siemens and Datex-Ohmeda GE are there. We plan to launch it but we have always said to you, we are going to get one shot in U.S. So we are very careful, we are doing all our analysis and that’s why we are very cautious and we are going to take it very carefully when we launch. But when we launch, we are going to launch it very aggressively and we have high hopes for it that we would capture a good share of the market.

Navid Malik

And for the final question. On the margins, on the Healthcare side hit 48%. Do you think that there’s a reasonable headroom for further margin expansion in the final quarter and then going into fiscal 2007? Are you able to rationalize some of your costs in your cost centers such as China and India?

Deepak Chopra

The answer is yes. We’ve told before that we think that we can cross the 50% mark. We might miss it by a quarter or so but we are on the right path. We believe that as our monitoring business continues to grow, it automatically has a higher margin. We continue to look at manufacturing in other areas to increase our efficiency. So it is absolutely true that we continue to move towards the 50% margin in the near future.

Navid Malik

Thanks with the questions and answers.

Operator

Your next question comes from Jeff Rosenberg with William Blair & Company, please proceed.

Jeff Rosenberg

Hi. Back to the gross margin, I wanted to ask you, given, I understand you are seeing improving gross margins in all the segments and that’s obviously having the most predominant effect but I was surprised given the makeshift moving away from Healthcare this quarter sequentially versus the Cargo business that gross margins still went up. So, can you provide a little cover there in terms of, it sounds like the Security gross margin was up particularly strong recently, maybe a little bit of specific commentary on the improvement there?

Deepak Chopra

Well I’ll answer the Healthcare side and Ajay can maybe take on the Security. On the Healthcare side, we did mention to you that this is going to be a weaker quarter in revenue wise compared to Q2 but even then, because the monitoring sales especially in U.S. was so strong which inherently has very high margins, Jeff. So that pushed the margin even with the revenue being down and our Optoelectronics business has performed very well in its margin and continues to do well and we think it will continue. Ajay, you want to comment on the Security side?

Ajay Mehra

Yes, I think if you look at the Security side, the margins have improved both to look at a growth on the conventional. We said as the sales go up, your related expenses don’t necessarily go up the same amount. So we’ve been able to leverage our margins as the sales volume has gone up and same thing is happening on the Cargo side. The other thing were doing on the Cargo side is, if you remember, nine months ago or a year ago, we were doing a lot of one-offs as we become more familiar with some of the products. Our margins have improved there as well.

Jeff Rosenberg

Okay. I went through before all the different line items on the P&L, but it sounds like what you’re pointing toward is the operating margin in this fourth quarter that you’ve seen it sometime, but there’s a lot of moving parts here and can you give us a flavor for, do you think you can achieve a mid-single digit operating margin this quarter or how should we get this, it seems like the gross margin should have another nice step-up with the make shifts will be more favorable and obviously there’s continued leverage there and with good revenue growth you’ll see some improvement in operating expenses? So, can you give us a feel for how that turns out in the operating margin line?

Deepak Chopra

Well, let me try to answer that you’ve (asked) a pretty tough question for us. Our revenue is going to be significantly up in Q4 compared to Q3. We also said Security will continue to be strong and we also said Q4 will be stronger than Q3 in Healthcare. Basically, you’re absolutely right that all these factors lead towards that the gross margins should be up. The problem we have is that we don’t know where the legal is going to fall. And like I said, we are in an active lawsuit right now. We have also the moving parts where Anuj mentioned about our tax rate and Sarbanes Ox expenses which start coming up in the Q4. So what we are trying to say is that if you take out some of these one-offs kind of thing that are happening, the operating income line will be significantly higher compared to Q3. But very difficult for us to project beyond that for this quarter. But on the operational side, the revenue is going to be up. All segments would be profitable and the operating income line will be significantly higher than Q3. Anuj, you want to add some more flavor to it?

Anuj Wadhawan

No, I mean you’ve said it, pretty much all that Deepak.

Jeff Rosenberg

Maybe I’m (inaudible) in looking at the fourth quarter, but if we look at ‘07, the legal expenses are much more normal and you got a gross margin that’s north of 40%. Can we expect you to get back to the 6% operating margin in ‘04 anyway, or maybe just some sense on what your targets are now that you have had chance to really drive some improvements and get some scale back in the Security business, where do you think we should look to when we look out the next fiscal year?

Deepak Chopra

I think that you’ve monitored it quite well. If you take out the legal expenses going in to 2007 and as Ajay says, the activity is quite strong and we can do growth in Healthcare, there’s no reason why we should not return back to overall company margin in the 40% plus or north of it and the return back to at least single digit operating income. Just keeping with one proviso that Ajay is saying that we are increasing on R&D spending in Automated Baggage Scanning business. But your analysis of it is right.

Jeff Rosenberg

Okay. You’ve given us in the past the absolute dollar number of shipments on the Cargo side? Is that the number that, I think you’re just talking in terms of incremental year over year growth. Last quarter I think you said the large Cargo was say, about $5 million, did that improve quarter on quarter?

Anuj Wadhawan

In this quarter, we shipped about $9.5 million in the large Cargo.

Jeff Rosenberg

Okay.

Anuj Wadhawan

And then, compared to $4.5, $4.7 million in the last year’s third quarter, and about $4.7 million in the second quarter of fiscal 2006.

Jeff Rosenberg

Okay. Great. And the last question I have was that you’re talking about the kind of double digit growth you’re seeing in the patient monitoring business but the overall Healthcare business was up less. Can you talk about where the business has been weaker in terms of what’s dragging the overall growth down of the revenue in the Healthcare group?

Deepak Chopra

Well, one of the things is that the European sector especially in U.K. and Germany, definitely the challenge for all of us because of their healthcare spending. The other thing is that our medical data on clinical trial business is weak, and that is dragging the growth down. On the other hand, monitoring which inherently has very high margin, continues to be strong. So, overall we are quite happy and you know, keep in mind the Oximetry business, I’m sure you know, have been in a sort of state of flux with this Masimo, Nellcor, which is part of Tyco, fight going on. It doesn’t have any impact on us presently or even in the future. But that definitely, everybody (inaudible) was sitting on the sideline, seeing what these two guys are going to battle it out. We didn’t have enough to lose, so we decided to just not even push forward with our digital oximetry business. So once that whole environment gets settled down, we continue to be believer in the rest of the oximetry business to continue.

Jeff Rosenberg

So, I think that to me, when I look at the significant jump that you’re expecting in the fourth quarter sequentially in terms of overall revenue, there’s not anything unusual, I mean there’ll be a seasonal recovery in Healthcare but that’s not enough to get you guidance. So you’ve got visibility into, I would take it to be a much stronger shipment quarter in terms of Cargo in this June quarter and maybe Ajay can talk about, given the overall lumpiness there, what’s your comfort level if that happens.

Deepak Chopra

Well, let me ask you again, let me answer the Medical side. Definitely Q4, seasonably and we have given guidance, will be stronger than Q3. On the Security side, Ajay you want to comment on it?

Ajay Mehra

Yes, Cargo is lumpy, but you’re sitting here today and like we’ve said, I do expect Security to be a better part of the fourth quarter than the third quarter.

Jeff Rosenberg

So, I think we’ll leave it at that. It is positive where we are in the third quarter.

Deepak Chopra

All right. Just to add on to it, Jeff, we did say that Cargo backlog should stand at about $43 million even with shipments of 9 million plus, and we also said that the total Security backlog is quite healthy.

Jeff Rosenberg

Right, so—

Ajay Mehra

And it’s just not Cargo, I mean, we’re seeing the growth in Cargo as well as conventional, Jeff.

Jeff Rosenberg

Right, and I understand that there is much more than a normal recovery seasonally, so to speak in your numbers. I’m assuming it’s a real stair step up in the Security business as well. We’re looking forward to make your guidance.

Deepak Chopra

That’s true.

Jeff Rosenberg

Okay. Thanks.

Operator

The next question comes from the line of Josh Jabs with Roth Capital, please proceed.

Josh Jabs

Hi guys. Good quarter. In looking at the backlog, how much of the Manchester order went into the Security backlog? Did you account for any of that?

Deepak Chopra

Ajay or Anuj, you want to take it?

Anuj Wadhawan

It’s approximately I think $7 million of the total in that.

Josh Jabs

Okay. So from the Manchester order, can I get going forward in the backlog will be $7 million until you start shipping out of the CT?

Anuj Wadhawan

That’s correct.

Josh Jabs

Okay. And then, I’m just going back to the tax rate. You know, we’ve had a little bit of fluctuation here, you talked about repatriation and some of the stuff you have going on with some of the foreign income. Is this something that we expect to continue to fluctuate over the next year? I mean, when is this going to settle down?

Anuj Wadhawan

This is just a one-time provision and a one-time opportunity we have. We can repatriate our foreign earnings.

Josh Jabs

Okay.

Anuj Wadhawan

But it expires on June 30th 2006.

Josh Jabs

Okay, and what kind of rate do you expect to give back to them after the next quarter?

Anuj Wadhawan

We see a lot of variables in there. As I mentioned earlier, mix of income, stock compensation expense, ISOs included in there. But if we exclude this repatriation, it’ll be somewhere in the neighborhood of 40% – 55%, somewhere in that neighborhood.

Josh Jabs

Okay.

Deepak Chopra

And Josh, this is Deepak, just to add on to another thing, I just want to make sure what you asked about the Manchester backlog. Manchester backlog would be in the total Security backlog, not in the large Cargo backlog, which is at $43 million.

Josh Jabs

Okay, that’s a good point. Then on the Dolphin settlement, you said that you didn’t expect significant impact there. Is there going to be any impact on the inter-company revenue, so their impact on the margin side?

Deepak Chopra

No. Inter-company revenue in that particular product line would be to Spacelab Healthcare for their Tru-Link oximetry product, which has nothing to do with Dolphin ONE or digital oximetry.

Josh Jabs

Okay. All right, and then, I guess finally just going back to the R&D issue again. I understand that you’re going to wrap R&D to get where you need to be on the Hold Baggage side. But you’ve talked about Healthcare being sort of flattish maybe a little down, and then the Cargo is obviously—is coming back in. So, if you look at the R&D line both from a percentage of revenue and also just from an absolute number, are we going to kind of settle in to the numbers that we’re seeing now? Do you expect this to still come up within that million range that Ajay had said before? I think there’s been some confusion there.

Deepak Chopra

Well, but let me try to answer. I don’t think that we ever said that the Healthcare R&D is going to go down. But as the revenues pick up, the percentage is pretty much way ahead right now. In the Security side, yes, the R&D is going to go up in the Automated Checked Baggage business but we also said the R&D in the large Cargo is going to go down. But the net impact is going to be, it’s still a little bit too early. But one of the things that you should look at it is because Q4 is going to be significantly stronger in revenue. As a percentage, I don’t think R&D is going to go up, it might even go down.

And on the Healthcare, the only (inaudible) thing that’s happened different is that we’ve been a little bit more efficient of the R&D engineering as we’re going in India compared to what we thought we’re going to cost, it’s costing us less.

Josh Jabs

Okay. Great. Thanks.

Operator

(Operator Instructions)

Our next question comes from the line of Tim Quillan with Stephens, Inc., please proceed.

Tim Quillan

Good afternoon. I apologize in advance, I wasn’t able to listen to the early part of the call, but, so some of these are going to be redundant, but what do you expect the tax rate to be in the fourth quarter?

Deepak Chopra

Anuj, do you want to take it?

Anuj Wadhawan

Yup. Tim I mentioned earlier, a lot of variables are going to be there. One is a mix of income between our foreign and domestic locations and ISOs included in a stock-based compensation expense, which doesn’t qualify for tax reduction. And the fourth quarter, we are expecting that the tax is going to get impacted because of repatriation of foreign earnings. That’s currently we are evaluating. Definitely, we will increase our effective tax rate. Combination of all that, I mean it’s a very broad range. It’ll be somewhere between 50-70%.

Deepak Chopra

But you also had said, Tim, if you were not there in the early part of the call that this repatriation is a one-off item that we have to do it before June 30th 2006.

Tim Quillan

Right. So 40-55% in 2007?

Deepak Chopra

Sorry?

Tim Quillan

40-55% though after this?

Deepak Chopra

Yes.

Tim Quillan

Okay. And then what was the total backlog?

Anuj Wadhawan

Total backlog was about $133 million, included in that large Cargo was about $43 million.

Tim Quillan

And what is the timing on the $43 million? What is the expected timing of shipments?

Deepak Chopra

Ajay, do you want to take it?

Ajay Mehra

Yes. The vast majority of that is going to be again it’s going to be within the next 12 months. I mean they’re obviously we’re shipping some fourth quarter, Q1, Q2 it’s going to be shipping on the next 12 months. New orders we get in take anywhere from four to nine months to ship. Some of the older orders we’re shipping, we’ll ship some in Q3, we’ll ship some in Q4 and Q1.

Tim Quillan

And can you talk about the pipeline a little bit, Ajay, especially with regards to Cargo screening. And I noticed that there’s a fair amount of funding in the pending Supplemental Appropriations Bill for containers screen. Is that something that is applicable to OSI?

Ajay Mehra

Yes it is. We’re—I mentioned earlier, if you look at our pipeline, if you look at activity out there, it’s very very strong, stronger than we’ve ever seen it both internationally and domestically. It’s a matter of as you know, what the government, it’s a matter of some of these budgets passing and getting some of the funds appropriated, but we feel very good about what we’re seeing out there right now.

Deepak Chopra

Just to add on to it Tim, that as you know, that we did announce some time ago an IDIQ order: Indefinite Quantity Indefinite Delivery. We have multiple products of large Cargo qualified in that program. And as the budget gets finalized and goes into the next year, starting October time period onwards, we definitely think that our products are needed for national security.

Tim Quillan

So, it is your understanding that the $200 million plus of funding for container screening that CBP has would be spent under the IDIQ?

Ajay Mehra

I think it will be inappropriate for me to answer that question. All I can tell you is that they have chosen different vendors and we are one of them under the IDIQ. Where they spend that $200 million, whether it’s all in the IDIQ or some of it, that’s a question you better ask to the U.S. Government. I don’t want to answer for them.

Deepak Chopra

Well, but maybe Ajay you can give some color relatively on last year, the total number available to them was significantly smaller than what they are trying to put through this year.

Ajay Mehra

That’s correct.

Deepak Chopra

So, that sort of gives you—them an indication that if we got some input in our order intake from last year, this year as the number goes significantly up that they’re asking for, but maybe they will be more available.

Tim Quillan

Right. Yes I like the sound of that. On the margin side, on the operating margin side, I was a little bit surprised in the composition, you touched on this a little bit, but the Heathcare margins were maybe a little bit lower than I would have anticipated granted in a seasonally weaker quarter, but the Opto margins were outstanding. Is there any trade-off between the inter-company work there? Is that all eliminated out? I mean is that all outside business margin that Opto is getting, or is there some kind of trade-off on who gets the saving from in-house manufacturing that the Opto is doing for Healthcare?

Deepak Chopra

Let me try to answer that question. We award this practice, arms-length transaction, between the Opto Group in a fair way to the divisions. The external sales are higher. That increases their margin and as they ship more inter-company, they do ship with margin. So when you add the two things together, definitely Optoelectronics Group generates very healthy operating income and we’ve said that before. But I won’t go as far as saying, is there some kind of a monitoring that we just divide a little bit here, a little bit there or whatever, that’s very well thought of arms-length transaction with what the fair pricing is between the manufacturing component group of Optoelectronics and the two divisions; Security and the Healthcare.

Tim Quillan

Okay. Yes, that’s helpful. Have you talked about what the legal cost have been year to date?

Deepak Chopra

Victor, Anuj, would you like to take a shot at it, but if you don’t, somebody can make a good estimate?

Anuj Wadhawan

It’s approximately $4.9 million to $5 million.

Tim Quillan

And in this quarter, the current quarter, it’s still pretty hard to estimate where your legal cost are going to end up?

Deepak Chopra

Well, we did say, I think that you were there in the call or not, that we can’t estimate, but we have the best guesstimate. We are in a four week trial as we speak. So we think that Q4, which is June ending, the legal cost will be higher than Q3 which Anuj mentioned, was approximately $2.7 million.

Tim Quillan

Okay.

Deepak Chopra

But it should go down after that significantly.

Tim Quillan

Right. Alright. Okay. In other than the legal cost, is there any initiative that might lower SG&A or do you expect SG&A cost to stay relatively flat in fiscal ’07, excluding the legal cost?

Deepak Chopra

Well, when you really look at it, one of the things that has happened. One, we definitely want to emphasize that we continue to look at our SG&A cost, but the new variable that has entered into it is this compensation expense that wasn’t there before, and now it’s in there, and that just having an impact in there and the R&D is up. So I think of it, I know that you continue to ask as a percentage of revenue as the revenue line picks up, the SG&A as a percentage of revenue, it should start coming up. Especially if you take the big element out of the legal effect and even after taking legal out, I think as the revenue line continues to grow, excluding the legal, the percentage SG&A should start coming down. Anuj, you and Ajay want to add something?

Anuj Wadhawan

No, I think that, I think you’ve said it well.

Tim Quillan

Okay. I was just looking at excluding stock option expense and excluding legal expense, you need about $30 million in SG&A in the third quarter. What I’m trying to figure out is can I kind of extrapolate that as a good run-rate that you don’t need to grow much in fiscal ’07? As your legal cost run off, maybe that would be a good run-rate that we should think about?

Deepak Chopra

I think that that’s a fair statement. Again, Anuj would you have a comment on it?

Anuj Wadhawan

No, that’s pretty much, Tim. That would be pretty much in that range.

Tim Quillan

Okay. That’s great. And then the management retention bonus is that, do we have one more quarter of that? Is that done?

Anuj Wadhawan

It’s already been done.

Tim Quillan

It’s done?

Anuj Wadhawan

Yes.

Tim Quillan

Okay, and you may have such touched on this, if you have don’t repeat yourself please, but can you talk about the situation with the auditor and why there was a severing of the relationship?

Deepak Chopra

Well, the issue basically was that, I think the relationship was the major issue, Tim. After 15 years of marriage I think fatigue was showing from both sides. Our biggest complaint had been that we just didn’t get their respect or called the priority. We were eight hours late on our year-end, a couple of days late on the quarter, and after Q2 it was pretty obvious that both sides were not being in a happy mode. So we actually had started dialogue even before Deloitte & Touche resigned.

I’ve started talking to and interviewing various potential but our plan was to look at a point after the third quarter. But Deloitte & Touche surprised us by resigning eight days to the quarter left. And then we had to actually aggressively go forward, and we had multiple choices. We had even choices in the end between Big 4, and going to a smaller regional firm, those are debated inside the company.

We basically get our analysis and said, what really was our biggest complaint was that respect and our ability to be on the front-side of the priority to get the answers. We thought that we would be better served with a regional firm. So it turned out that Moss Adams had their headquarters in Seattle, they had offices in Los Angeles. And basically we are very happy with what we have seen, and you can see that we were very worried about the timing, and in that motion, we can tell you that we have not filed the (NYSE:Q) yet, but we are timing the (Q) to be any day, and we think it’s in the next couple of days.

We think that if we were with a Big 4, this would have been very difficult, we won’t get to this. It’s been a great four weeks including midnight oil burning from both the auditors and inside. But we are very happy with the service we’re getting.

Tim Quillan

And was there any specific accounting issue that brought the shaky marriage to an end with Deloitte?

Deepak Chopra

No. When they resigned, there was no item that was opened. Q2 had already been signed out, Q3 they have not even started, so it was in between with no open issues left.

Victor Sze

I think, Deepak, you can add to it that Deloitte was very helpful and very instrumental in our bringing aboard a new audit firm. They expressed some very positive sentiments about us and did say that (inaudible) business relationship issue and beyond that they had no concerns about us.

Deepak Chopra

But just to add on to it that internationally, with our independent offices, I think in Asia Pacific, Anuj, what Malaysia or Singapore or where is it?

Anuj Wadhawan

Malaysia and Singapore both.

Deepak Chopra

Malaysia and Singapore, Tim, Deloitte & Touche is still our auditors.

Tim Quillan

Okay.

Anuj Wadhawan

And, Tim, all the open items which were there not opened but to all the significant deficiencies and material weaknesses, those we had were already disclosed in our eighth day.

Tim Quillan

Right. Okay. Okay, thanks gentlemen.

Operator

There are currently no questions in queue.

Deepak Chopra

With that, I’d like to end it. I want to thank you very much for this late evening, at quarter to seven on the East Coast. We appreciate your time. We believe that we are poised for a good 2007. We continue to look at all our segments and we are very comfortable in saying that in Q4, revenues would be stronger than Q3, operating income will be significantly stronger, and all three segments will be profitable, Security will have a good Q4, better than Q3.

Going into 2007, we are looking at a growth and we are looking at a positive movement to get towards profitability. Margins continue to improve and we are looking forward to ending one of the litigation this quarter so that we could go start the New Year with one less litigation. Thank you.

Operator

Thank you for your attendance in today’s conference. This concludes our presentation. You may now disconnect. Good day.

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Source: OSI Systems, Inc. Q3 2006 Earnings Conference Call Transcript (OSIS)
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